Billabong dumped by financial currents

Derek O’Neill, the boss of surf and board sports company
Billabong International
, no doubt would rather have been hanging out at the Billabong Pipe Masters contest in Hawaii this week than delivering a significant earnings downgrade.

Billabong is one of Australia’s most-loved homegrown brands, founded in 1973 by Gordon Merchant at Burleigh Heads on the Gold Coast, which has grown into a global operation with a market capitalisation of more than $2 billion.

It counts some of the world’s best surfers as part of its stable of stars such as
Taj Burrow
and
Joel Parkinson
and sponsors top events like the legendary surf contest at Hawaii’s North Shore.

But in recent years Billabong has slipped in the face of the global financial crisis, volatile foreign exchange rates, integration costs of acquisitions and more recently a poor Australian retail market.

Billabong has downgraded market expectations four times in two years and therefore runs the risk of investors discounting its outlook statements and guidance.

Investors are left wondering what the one-time market darling that in 2007 traded on a price to earnings ratio of 28 times and a share price of nearly $18, has left to give. This week the company cut its earnings expectations for the year as wet weather, low repeat orders and weak consumer spending affected trade at a critical time.

First-half constant currency net profit could be as much as 13 per cent lower compared with flat expectations previously. Full-year net profit is now tipped to be flat compared with prior guidance for between 2 and 8 per cent growth.

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“We met our constant currency guidance last year but when turned into reported Australian dollars, positive growth turned into negative growth. We are an international company and we have to take the lumps when the currency rises," he says.

About 80 per cent of revenue comes from offshore and therefore is affected by currency movements. Taking currency into account, Billabong warned that full-year net profit could be down by 10 per cent on last year’s $146 million.

Billabong’s strategic move into becoming a fully integrated retailer with its own company-owned stores, increasing from 16 per cent in 2007 to about 40 per cent in 2011, has been questioned by the market. It has also been a serial acquirer. Including its flagship brand Billabong, it also owns Element, Nixon, Von Zipper, Kustom, Sector 9, Xcel, DaKine, Honolua Surf Co, Palmers Surf, Tigerlilly and RVCA. It operates in 100-plus countries and more than 10 retail formats with no formalised plan for integration.

“The complexity of the business has been escalating [with acquisitions]," Morgan Stanley analyst Tom Kierath says. “The more brands, retailers and countries that Billabong operates in the more difficult the business becomes to manage. No other company in our coverage universe has so many moving parts."

Kierath says earnings transparency is also a problem, as it appears that management either needs to have a firmer grip on profit drivers or the key profit drivers are outside the control of management.

CBA analyst Andrew McLennan says he has “material concerns" around the retail strategy.

“Over the last few years, Billabong’s unfettered acquisition-fuelled growth strategy has converted the company from a high-return, low-geared operation into the exact opposite: low returns, higher cyclicality and higher gearing," he says.

McLennan adds that, while the Billabong brand has a very strong presence in the retail surf channel, there is a trend towards newer brands.

“Retailers are now looking for their own private label opportunities to improve margins and newer brands," he says. “The overall surf category has been adversely affected by fashion trends."

McLennan says organic earnings growth has been deteriorating for several years, mostly due to currency, and that might even out over time.

“Once acquisitions start marking a stronger contribution and if the currency stops appreciating, you might see some decent growth coming through," he says.

Almost all of Billabong’s design is done in-house, with the exception of working with some external artists on special projects. Some say its flagship brand Billabong – which accounts for around 50 per cent of revenue, including sales into its own retail outlets – has lost some cool factor, something O’Neill denies.

“Surf goes though various trends, sometimes it’s good for us and sometimes it’s not," O’Neill says. “We don’t want to turn the Billabong brand into Diesel or any other urban brand."

O’Neill says Billabong has embraced a lot of the new looks and is dusting off some of its earlier design books and adapting those looks.

“We need to remain true to our brand and ultimately we are not going to be a high end fashion brand," he says.

O’Neill admits that the group’s ability to be a retailer will only be proved over time.

“Investors understand that standing still and doing nothing in a volatile wholesale market is not really a strategy," he says. “There is still a question mark on our ability to operate retail. That ability will only be proved over time. We are still yet to really influence the floor product. But we remain confident that getting product in front of the consumer the way we want it is preferable. The retail strategy should prove sound."

O’Neill says Billabong might be lose floor space in certain stores but gain in others, and he tries to avoid putting pressure on a brand to achieve sales, which can damage long-term standing.

But several analysts say they are worried about unsold summer stock in Australia that has not been discounted to sell which could affect the second half.

“But not moving stock quickly will mean Billabong’s wholesale customers and competitors will discount and Billabong will be left with excess inventory for longer," McLennen says. “They have a brand manger mindset rather than retailer mindset."

Deutsche Bank analyst Alexi Baker-McLennan says while 2011 expectations have been wiped out, a longer-term story is intact and he believes the company has several strong growth drivers, including exposure to the US recovery.